The explosive growth in hedge funds is causing major concern for financial regulators who worry that a collapse of a major fund will have an enormous knock-on effect that could destabilise the international financial system.

This week international regulators will meet senior financial industry executives in New York to discuss measures to reduce the risks posed by a hedge fund collapse.

Most of us in the lower reaches of the financial food chain will never have direct dealings with hedge funds. Once the preserve of the very rich, hedge funds are investment vehicles, typically organised as private partnerships and often located offshore to keep taxes and regulatory oversight to a minimum. Hedge funds offer high rewards, but take big risks in order to achieve them.

Attracted by high returns in recent years, banks and other established financial institutions have jumped on to the hedge fund bandwagon. Last year, assets under management by hedge funds grew by about a fifth. Hedge funds now manage $1,000bn (£550bn) in assets spread across 7,500 funds, according to the International Monetary Fund.

Recently, BNP Paribas Asset Management of France merged its hedge fund group with Fauchier Partners, taking a majority stake in the new company. JP Morgan Chase, the US financial firm, took a majority stake in Highbridge Capital Management, while Citigroup, also of the US, is building up its hedge fund expertise internally.

Last year the Rail Pension Fund in the UK decided to invest about £600m, or 5% of its total assets to boost returns, so even some small investors now have at part of their savings tied up to hedge funds.

AW Jones established in 1949 in the US what is regarded as the first hedge fund, combining two investment tools: short selling and leverage. Short selling involves borrowing a security and selling it in anticipation of buying it back for a lower price when or before it has to be repaid to the lender. Leverage is financial jargon for using borrowed money.

Hedge funds proliferated in the mid-60s during a stock market boom, fell out of fashion in the market downturn of 1968 and made a comeback in the late 80s after the success of such funds as the Tiger Fund.

The one hedge fund that made an impact on public consciousness was Long-Term Capital Management, founded by John Meriwether, the famed bond trader from Salomon Brothers, and boasting two Nobel-prize winning economists, Myron Scholes and Robert Merton, on its board.

LCTM took highly leveraged positions (borrowed huge amounts of securities from commercial and investment banks) in order to profit from often small discrepancies in the relative prices of financial instruments such as bonds, swaps and options as well as shares and derivatives.

As long as LCTM guessed correctly which way those prices were heading, it made money. Initially it enjoyed returns that averaged 33% annually, easily beating the market. But in August 1998, Russia devalued the rouble and declared a moratorium on its government bonds.

As a result, there was a massive "flight to quality", with investors flooding out of any remotely risky market and into the most secure instruments, such as US treasury bonds. Amid this market nervousness, investors wanted their money back from LCTM.

But the fund could not repay investors as its liabilities vastly exceeded its assets. LCTM had an exposure equivalent to 28 times its assets. Fearful of the knock-on effects of a collapse at LCTM, the financial authorities in the US stepped in to arrange an orderly payout of the firm's liabilities.

Hedge funds have learnt the lessons of LCTM. The average hedge fund's leverage is now just 2.5 times its assets instead of LCTM's wildly high numbers. But there are more hedge funds than ever and the fear is that a collapse of several of them could precipitate a financial crisis.

In recent weeks, a British hedge fund, Bailey Coates Asset Management, has been in the news. The Mayfair-based fund, run by Jonathan Bailey, 36, and Stephen Coates, 33, incurred losses of nearly 10% in April on top of a 5% fall in March and negative returns in February.

The fund, which specialises in taking contrarian views on companies across the world, has seen its assets under management fall from $1.3bn last year to less than $750m.

The hedge fund industry was hurt after Standard & Poor's, the credit ratings agency, earlier this month cut the bond ratings of GM and its finance company, General Motors Acceptance, making the world's largest car maker the biggest ever company to have its debt rated as junk. S&P also cut Ford Motor's bonds to junk.

GM and Ford have issued some $460bn in bonds, making them among the world's biggest issuers of bonds. Although the downgrades had been expected for some time, some hedge funds were still caught out.

Many thought the downgrade was in the price, but they had not realised that many debt holders would be obliged by their own investment rules to sell junk-rated bonds. These forced sales led to a steeper fall in the price of GM and Ford bonds than hedge funds had anticipated.

Alan Greenspan, the US Federal Reserve chairman, said earlier this month that the growth in hedge fund assets created the potential for "unanticipated losses to investors". He also said banks that lent to hedge funds should re-examine their lending conditions and the amount of information they received about the funds' holdings. That would be a useful starting point for international regulators.